Last night a story broke that Japan’s Softbank had reached a deal to buy a controlling stake in Sprint ($S: long). The deal structure is kinda interesting, and this morning we got the actual finalized details. I had some people on Stocktwits last night asking me to explain why, in fact, Sprint stock would not trade at $7.30 this morning, and I figured I’d write a post about it.

First, let’s suspend reality for a bit, and alter the actual terms of the deal slightly to make it easier to understand. These are NOT the actual terms of the deal, but the actual deal terms will be virtually identical in effect to these. So, Softbank will

1) buy $ 3.1 Billion of 7 year 1% convertible bonds directly from Sprint, with a conversion price of $5.25.

Again, these are not the actual deal terms, but they will help us understand how the deal will work.

So if you’re a current Sprint shareholder, you can decide a) do I want to sell my shares to Softbank for $ 7.30 each? or b) do I want to remain a shareholder in the new company? There are 3 Billion Sprint shares currently outstanding, however, and Softbank will only be buying 1.67 Billion of those, or 55% of them. So when we calculate where Sprint should trade TODAY, we need to account for the fact that we won’t be able to tender every share to Softbank.

In other words, the current value of Sprint is a combination of 1) the value that we get for our tendered shares and 2) the residual value of the remaining shares. What will the residual value be? Well, that’s not a trivial calculation or a known number – we need to estimate it. Normally, we arbs would use some sort of normalized trading price pre-deal for an assumption of where the stock will trade when the deal is done. In other words, something around $5 per share (the stock rallied to $6 on Friday on rumors of a deal). There is a lot of subjectivity in this number though, and it’s further complicated by the unusual deal structure that results in Sprint raising significant funds in the deal ($8 billion, in fact – the sum of the convert and the directly purchased shares). In most mergers, the existing shareholders are the ones receiving cash (or stock). In this deal, both the company and the existing shareholders are involved in recapitalization.

Now, if all the current Sprint shareholders want cash, then the “proration” rate will be 55%. This means that 55% of our shares will be accepted by Softbank and paid $7.30 each. We would be left with 45% of our initial position in stock. If fewer shareholders want cash, then the proration rate might be higher: shareholders who want cash will get more than 55% in cash. You can make yourself a little spreadsheet with the two main variables: 1) your estimate for the post-tender price per share of Sprint and 2) your estimate of the proration. You can combine the two variables and get your weighted estimates of the current value of Sprint. I made one such spreadsheet here, but note that I did NOT account for the fact that the tender will take some time to complete, and that arbs will discount that future value at their required rate of return*:

Ok – so now we should all hopefully understand why Sprint isn’t trading at $7.30, or even at the discounted present value of $7.30 this morning: it’s because, to simplify it all the way: Sprint shareholders won’t get $7.30 for each and every one of their shares.

Now we get to the final wrinkle: remember how I told you that the deal terms I laid out were not the actual deal terms? Softbank and Sprint structured this deal not as a cash tender, but rather as a merger where Softbank would capitalize a new entity, and then swap shares of that new entity for shareholders who didn’t want cash, and for shareholders left over after the allocated cash is spent on the tender. Don’t panic or get too confused – the ultimate effect is almost identical to the tender structure that I described above, although with the merger structure (as opposed to the tender structure) there may be a difference in how non-electing shareholders are treated**, and there may be differing tax consequences. Here are the actual deal terms from the 8-k filing (again, don’t freak out – it’s substantially identical in effect to the structure I described above)

Transaction Terms

•

SoftBank will form a new U.S. subsidiary, New Sprint, which will invest $3.1 billion in a newly-issued Sprint convertible senior bond following this announcement. The convertible bond will have a 7-year term and 1.0% coupon rate, and will be convertible, subject to regulatory approval, into Sprint common stock at $5.25 per share. Immediately prior to the merger, the bond will be converted into shares of Sprint, which will become a wholly-owned subsidiary of New Sprint.

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Following Sprint stockholder and regulatory approval, and the satisfaction or waiver of the other closing conditions to the merger transaction, SoftBank will further capitalize New Sprint with an additional $17 billion and effect a merger transaction in which New Sprint will become a publicly-traded company and Sprint will survive as its wholly-owned subsidiary. Of the $17 billion, $4.9 billion will be used to purchase newly issued common shares of New Sprint at $5.25 per share. The remaining $12.1 billion will be distributed to Sprint stockholders in exchange for approximately 55% of currently outstanding shares. The other 45% of currently outstanding shares will convert into shares of New Sprint. SoftBank will also receive a warrant to purchase 55 million additional Sprint shares at an exercise price of $5.25 per share.

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Pursuant to the merger, holders of outstanding shares of Sprint common stock will have the right to elect between receiving $7.30 per Sprint share or one share of New Sprint stock per Sprint share, subject to proration. Holders of Sprint equity awards will receive equity awards in New Sprint.

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Post-transaction, SoftBank will own approximately 70% and Sprint equity holders will own approximately 30% of New Sprint shares on a fully-diluted basis.

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SoftBank is financing the transaction through a combination of cash on hand and a syndicated financing facility.

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The transaction does not require Sprint to take any actions involving Clearwire Corporation other than those set forth in agreements Sprint has previously entered into with Clearwire and certain of its shareholders.

disclosure: I bought shares of $S this morning at 5.88. I may sell them at any point in time. I may buy more.

* the required annualized rate of return is a function of how much risk there is that the deal will break

** in a normal tender, shareholders who fail to tender essentially “do nothing.” In some merger elections, however, non-electing shareholders don’t always receive the under-subscribed election option (new shares, in this case) – sometimes they receive a blended average of cash & stock. The details of the election process are not yet published.

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